American Electric Power: Whether Its Recent 'Love' Is Justified

American Electric Power (NYSE:AEP) has been getting a lot of love recently. Multiple articles, from Forbes to SeekingAlpha, are touting its cheap valuation. For example, recently interviewed in a Forbes article, Mr. Sam Stovall, chief investment strategist, Standard & Poor’s said, “We have a strong buy recommendation for AEP. Its dividend yield is above its peers. It is currently at 4.9%, which is slightly above the industry average. That makes the shares compelling for their total return potential. We expect full-year earnings to reflect the benefit of more than $200 million in rate hikes, and a rebound in industrial sales where second-quarter sales volume increased to 95% of pre-recession levels. Over the next few years, we expect earnings growth to be driven by the company’s investments and its transmission and generation operations.” Forbes article is found here.

Investors have been piling on, pushing prices up to almost new 52-week highs and trading volume has picked up substantially since the middle of July.

AEP is the fifth largest electric utility, by market capitalization. It operates 39,900 MW of generation along with an extensive transmission system. Serving over five million clients, AEP owns 11 utilities in 10 states and operates primarily in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia, and West Virginia. The company currently relies on regulated operations for 95% of earnings with 40% of earnings derived in Ohio, but that is changing.

There are several rate cases pending in Ohio that should be resolved by year-end, include a transition to a market rate pricing structure and a boost in transmission rates. Combined, these could equate to about $150 to $250 million in rate increases in 2012 and 2013. There are also ongoing rate cases pending in Michigan and Virginia.

An improving Midwest industrial customer base will fuel growth in electricity demand across its service area. So far this year, electricity demand from its industrial and commercial clients has increase by 5%. AEP derives 35% of its revenues from these clients, a higher percentage than many of its peers. AEP has a large exposure to coal-fired power generation and anticipates spending four to six billion dollars to upgrade their facilities to meet higher EPA regulations. Offsetting this capital expenditure will be rate increases as environmental upgrades adds to its capital base. Between 2012 and 2014, the company expects to close several coal-fired plants totaling almost 6,000 MW of generation capacity as uneconomical for upgrades, while new planned capacity between now and 2020 should replace about 2,500 MW.

In addition, AEP is the largest electricity transmission company in the U.S. with over 39,000 miles of transmission lines, along with operating the largest network of extra-high voltage lines. AEP is very well position to take advantage of the government’s push for expansion and increased efficiency of the Power Grid.

Like most utilities, AEP’s fuel selection for power generation is changing with natural gas replacing coal. Below outlines total generation capacity and the percentage of each type of fuel used:

1990

2010

2020

Fuel Source

Coal

75%

65%

51%

Natural Gas

16%

23%

28%

Hydro/Wind/Solar

1%

7%

15%

Nuclear

8%

5%

6%

AEP earned $3.10 per share in 2010 and is expected to earn $3.13 this year, $3.25 next and upwards of $3.40 in 2013. Although the five-year EPS growth rate has been a disappointing 0%, the firm is expected to get back to its winning ways with 4.5% to 5.0% growth rate going forward, similar to its’ large-cap peers. Five-year return on invested capital is 5.3%, also a middle-of-the-pack result among its peers.

While earnings have been flat, dividends have grown at an average rate of 3.8% over the past five years. Dividends represent a 58% payout ratio and are expected to increase by its tradition 3.5% to 4.0% annually. The current yield of 4.9% is above its five-year average of 4.4%. AEP offers a dividend reinvestment and direct stock purchase plan.

Two weeks ago, AEP reached a tentative settlement with Ohio regulatory agencies to overhaul how the company operates. While the complex and tentative changes still require final agency approval, when effective, will have a pronounced affect in AEP’s business model and profitability in Ohio. Over time, AEP’s Ohio business will transition into a market-based merchant power provider from its current regulated monopoly position. More information on the settlement is here.

Ohio represents a significant portion of current earnings. With the transition, AEP will effectively reduce its overall regulated utility business model to 70% to 75% of earnings. With upwards of 25% to 30% of future earnings in 2015 and beyond reliant on merchant power market pricing rather than regulated pricing, the company’s risk profile changes, and with it the potential for higher merchant power operating profits. AEP will be more in tune with hybrid electric utilities, such as Exelon (NYSE:EXC), Public Service Enterprise (NYSE:PEG), Entergy (NYSE:ETR), and FirstEnergy (NYSE:FE) rather than its current highly regulated peers of Ameren (NYSE:AEE), Alliant (NYSE:LNT), Duke Energy (NYSE:DUK), Southern Company (NYSE:SO) and Xcel Energy (NYSE:XEL).

While valued a bit lower than its regulated peers, AEP is trading at about parity with its new, hybrid peer valuations. The overlooked opportunity lies in its growing transmission footprint. AEP offers a peer-average current yield and is trading at $38, with a reasonable price target in the low $40s going out a few years. While not a barnburner, AEP offers a steady dividend generated by conservative managers who are positioning the company for consistent performance. Total Stock Returns should be in the 8.5% to 9.5% range.

However, investors need to appreciate that AEP is a company in transition, and that transition not only will take time, but also carries its own execution risks.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

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